Forex Derivatives - NSE

8/2/2019 Forex Derivatives - NSE

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CONTENTS

CHAPTER 1....................................................................................................................................................3

INTRODUCTION TO FOREX AND FOREX DERIVATIVES .....................................................3

1.1 BASICFOREIGNEXCHANGEDEFINITIONS ....................................................................3

1.2 DERIVATIVESDEFINED.......................................................................................................... 4

1.3 FACTORSDRIVINGTHEGROWTHOFDERIVATIVES .................................................5

1.4 DERIVATIVEPRODUCTS ........................................................................................................6

1.5 PARTICIPANTSINTHEDERIVATIVESMARKETS........................................................7

1.6 ECONOMICFUNCTIONOFTHEDERIVATIVESMARKET ..........................................7

1.7 EXCHANGE-TRADED VS.OTCDERIVATIVESMARKETS ..........................................9

CHAPTER 2..................................................................................................................................................12

INTRODUCTION TO CURRENCY FUTURES ...............................................................................12

2.1 DEFINITIONOFCURRENCYFUTURES ...........................................................................12

2.2 FUTURES T ERMINOLOGY.............................................................................................................. 132.3 RATIONALEFORINTRODUCINGCURRENCYFUTURES ........................................14

2.4 DISTINCTIONBETWEENFUTURESANDFORWARDSCONTRACTS ................... 17

2.5 INTEREST RATE PARITY PRINCIPLE............................................................................................. 17

CHAPTER 3..................................................................................................................................................20

NSES CURRENCY DERIVATIVES SEGMENT ............................................................................20

3.1 PRODUCTDEFINITION.......................................................................................................... 20

3.2 TRADING UNDERLYING VERSUS TRADING FUTURES................................................................ 21

3.3 FUTURES PAYOFFS........................................................................................................................ 23

3.4 PRICING FUTURES COST OF CARRY MODEL............................................................................. 25

3.5 PRICING STOCK FUTURES............................................................................................................. 28

3.6 PRICING CURRENCY FUTURES ..................................................................................................... 30

3.7 PARTICIPANTSANDFUNCTIONS ..................................................................................... 31

3.8 USESOFCURRENCYFUTURES.......................................................................................... 32

CHAPTER 4..................................................................................................................................................35

TRADING......................................................................................................................................................35

4.1 CURRENCY DERIVATIVES TRADING SYSTEM............................................................................. 35

4.1.1 Entities in the trading system............................................................................................35

4.1.2 Basis of trading....................................................................................................................37

4.1.3 Corporate hierarchy...........................................................................................................374.1.4 Client Broker Relationship in Derivatives Segment......................................................39

4.1.5 Order types and conditions...............................................................................................40

4.2 THE TRADER WORKSTATION ....................................................................................................... 42

4.2.1 The market watch window .................................................................................................42

4.2.2 Inquiry window....................................................................................................................42

4.2.3 Placing orders on the trading system..............................................................................43

4.2.4 Market spread order entry................................................................................................44

4.3 FUTURES MARKET INSTRUMENTS............................................................................................... 45

4.3.1 Contract specifications for currency futures..................................................................45

4.4 CHARGES........................................................................................................................................ 46


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CHAPTER 5..................................................................................................................................................48

CLEARING AND SETTLEMENT ........................................................................................................48

5.1 CLEARING ENTITIES...................................................................................................................... 48

5.1.1 Clearing members ...............................................................................................................48

5.1.2 Clearing banks.....................................................................................................................48

5.2 CLEARING MECHANISM................................................................................................................ 495.3 SETTLEMENT MECHANISM............................................................................................................ 51

5.3.1 Settlement of currency futures contracts.........................................................................51

5.4 RISK MANAGEMENT...................................................................................................................... 53

5.5 MARGININGSYSTEM ............................................................................................................. 55

5.5.1 NSCCL- SPAN..................................................................................................................55

5.5.2 SPAN approach of computing initial margins............................................................56

5.5.3 Types of margins .................................................................................................................56

5.5.4 Calendar Spread :...............................................................................................................57

CHAPTER 6..................................................................................................................................................59

REGULATORY FRAMEWORK...........................................................................................................59

6.1 REGULATORYFRAMEWORKFOROTCDERIVATIVES ........................................... 59

6.2 CURRENCYFUTURES ............................................................................................................61

6.2.1 RBI-SEBI Standing Technical Committee on Exchange Traded Currency Futures61

6.2.2 Securities Contracts (Regulation) Act, 1956..................................................................62

6.2.3 Securities and Exchange Board of India Act, 1992.......................................................63

6.2.4 Regulatory framework for Product Design ....................................................................64

6.2.5 Regulatory framework for Exchanges .............................................................................64

6.2.6 Regulatory framework for Clearing Corporation.........................................................65

6.2.7 Governing Council of the Exchange and Clearing Corporation.................................65

6.2.8 Eligibility criteria for members .........................................................................................656.3 ACCOUNTING................................................................................................................................ 73

6.3.1 Accounting at the inception of a contract......................................................................74

6.3.2 Accounting at the time of daily settlement.....................................................................75

6.3.3 Accounting for open positions.........................................................................................75

6.3.4 Accounting at the time of final settlement......................................................................76

6.3.5 Accounting in case of a default........................................................................................76

6.3.6 Disclosure requirements ...................................................................................................77

6.4 TAXATION OF DERIVATIVE TRANSACTION IN SECURITIES....................................................... 77

6.4.1 Taxation of Profit/Loss on derivative transaction in securities ..................................77

MODEL TEST..80

Dist r i bu t i on o f w e igh t s in t heFEDAI -N SE Cur ren cy Fut ur es ( Bas ic) Mo du le Cur r icu l um

ChapterNo.

T i t le Weights( % )

1 Introduction to Forex and Forex Derivatives 102 Introduction to Currency Futures 103 NSEs Currency Derivatives Segment 204 Trading 20

5 Clearing and Settlement 206 Regulatory framework 20


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CHAPTER 1

I NTRODUCTI ON TO FOREX AND FOREXDERI VATI VES

The foreign exchange (currency or forex or FX) market exists wherever one

currency is traded for another. It is the largest and most liquid financialmarket in the world. Exchanging currencies can take two basic forms: an

outright or a swap. When two parties exchange one currency for another thetransaction is called an outright. When two parties agree to exchange and re-exchange (in future) one currency for another, it is called a swap.

1.1 BASI C FOREI GN EXCHANGE DEFI NI TIONS

Spot : Foreign exchange spot trading is buying one currency with a different

currency for immediate delivery. The standard settlement convention forForeign Exchange Spot trades is T+2 days, i.e., two business days from thedate of trade execution. An exception is the USD/CAD (US Canadian Dollars)currency pair which settles T+1. Rates for days other than spot are alwayscalculated with reference to spot rate.

F o r w a r d O u t r i g h t : A foreign exchange forward is a contract between twocounterparties to exchange one currency for another on any date after spot.In this transaction, money does not actually change hands until some agreedupon future date. The duration of the trade can be a few days, months oryears. For most major currencies, three business days or more after deal datewould constitute a forward transaction.

Se t t l e m e n t d a t e /

Va lue Date

D e f i n i t i o n

Value Cash Trade Date Same day as deal dateValue Tom (Tomorrow) Trade Date + 1 1 business day after

deal dateSpot Trade Date + 2 2 business days after

deal date*

Forward Outright Trade Date + 3 or anylater date

3 business days or moreafter deal date, alwayslonger than Spot

* USDCAD is the exception and trades T+1


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B a se Cu r r e n c y / T er m s Cu r r e n c y : In foreign exchange markets, the basecurrency is the first currency in a currency pair. The second currency is calledas the terms currency. Exchange rates are quoted in per unit of the base

currency. E.g. the expression Dollar Rupee, tells you that the Dollar is beingquoted in terms of the Rupee. The Dollar is the base currency and the Rupee

is the terms currency.

Exchange rates are constantly changing, which means that the value of one

currency in terms of the other is constantly in flux. Changes in rates areexpressed as strengthening or weakening of one currency vis--vis the secondcurrency. Changes are also expressed as appreciation or depreciation of onecurrency in terms of the second currency. Whenever the base currency buysmore of the terms currency, the base currency has strengthened / appreciated

and the terms currency has weakened / depreciated. E.g. If Dollar Rupeemoved from 43.00 to 43.25. The Dollar has appreciated and the Rupee hasdepreciated.

Sw a p s : A foreign exchange swap is a simultaneous purchase and sale, or vice

versa, of identical amounts of one currency for another with two differentvalue dates.

The two currencies are initially exchanged at the Spot Rate and are exchangedback in the future at the Forward Rate. The Forward Rate is derived by

adjusting the Spot rate for the interest rate differential of the two currenciesfor the period between the Spot and the Forward date. Liquidity in onecurrency is converted into another currency for a period of time. FX Swaps are

commonly used as a way to facilitate funding in the cases where funds areavailable in a different currency than the one needed. Effectively, each partyis given the use of an amount of foreign currency for a specific time .

The emergence of the market for derivative products, most notably forwards,

futures and options, can be traced back to the willingness of risk-averseeconomic agents to guard themselves against uncertainties arising out offluctuations in asset prices. By their very nature, the financial markets aremarked by a very high degree of volatility. Through the use of derivative

products, it is possible to partially or fully transfer price risks by locking-inasset prices. As instruments of risk management, these generally do not

influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations inasset prices on the profitability and cash flow situation of risk-averse

investors.

1.2 DERI VATI VES DEFI NED

Derivative is a product whose value is derived from the value of one or more

basic variables, called bases (underlying asset, index, or reference rate), in acontractual manner. The underlying asset can be equity, foreign exchange,


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commodity or any other asset. For example, wheat farmers may wish to selltheir harvest at a future date to eliminate the risk of a change in prices bythat date. Such a transaction is an example of a derivative. The price of this

derivative is driven by the spot price of wheat which is the "underlying".

In the Indian context the Securities Contracts (Regulation) Act, 1956

(SC(R)A) defines "derivative" to include-

1. A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other formof security.

2. A contract which derives its value from the prices, or index of prices, of

underlying securities.

Derivatives are securities under the SC(R)A and hence the trading of

derivatives is governed by the regulatory framework under the SC(R)A.

The term derivative has also been defined in section 45U(a) of the RBI act as

follows:

An instrument, to be settled at a future date, whose value is derived from

change in interest rate, foreign exchange rate, credit rating or credit index,price of securities (also called underlying), or a combination of more than

one of them and includes interest rate swaps, forward rate agreements,foreign currency swaps, foreign currency-rupee swaps, foreign currencyoptions, foreign currency-rupee options or such other instruments as may bespecified by the Bank from time to time.

Derivative products initially emerged as hedging devices against fluctuations in

commodity prices, and commodity-linked derivatives remained the sole form of

such products for almost three hundred years. Financial derivatives came intospotlight in the post-1970 period due to growing instability in the financial markets.However, since their emergence, these products have become very popular and by1990s, they accounted for about two-thirds of total transactions in derivativeproducts. In recent years, the market for financial derivatives has grown

tremendously in terms of variety of instruments available, their complexity and alsoturnover.

B o x 1 . 1 : Em e r g e n c e o f f i n a n c i al d e r i v a t i v e p r o d u c t s

1.3 FACTORS DRI VI NG THE GROWTH OF DERIVATI VES

Over the last three decades, the derivatives market has seen a phenomenal

growth. A large variety of derivative contracts have been launched atexchanges across the world. Some of the factors driving t he growth offinancial derivatives are:


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1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international

markets,

3. Marked improvement in communication facilities and sharp decline in their

costs,

4. Development of more sophisticated risk management tools, providing

economic agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and

returns over a large number of financial assets leading to higher returns,

reduced risk as well as transactions costs as compared to individualfinancial assets.

1.4 DERIVATI VE PRODUCTSDerivative contracts have several variants. The most common variants are

forwards, futures, options and swaps. We take a brief look at variousderivatives contracts that have come to be used.

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today's pre-agreedprice.

Futures : A futures contract is an agreement between two parties to buy or sell anasset at a certain time in the future at a certain price. Futures contracts are special

types of forward contracts in the sense that they are standardized exchange-traded contracts.

Opt ions : Options are of two types - calls and puts. Calls give the buyer theright but not the obligation to buy a given quantity of the underlying asset, at

a given price on or before a given future date. Puts give the buyer the right,but not the obligation to sell a given quantity of the underlying asset at a givenprice on or before a given date.

W a r r a n t s : Options generally have lives of upto one year, the majority of

options traded on options exchanges having a maximum maturity of ninemonths. Longer-dated options are called warrants and are generally tradedover-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of upto three years.

Bas k e ts : Basket options are options on portfolios of underlying assets. Theunderlying asset is usually a moving average of a basket of assets. Equity

index options are a form of basket options.


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Sw aps: Swaps are private agreements between two parties to exchange cash flowsin the future according to a prearranged formula. They can be regarded as

portfolios of forward contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cashflows between the parties in the same currency.

Currency swaps: These entail swapping both principal and interestbetween the parties, with the cash flows in one direction being in adifferent currency than those in the opposite direction.

Swapt ions : Swaptions are options to buy or sell a swap that will become

operative at the expiry of the options. Thus a swaption is an option on a forwardswap. Rather than have calls and puts, the swaptions market has receiverswaptions and payer swaptions. A receiver swaption is an option to receive fixed and

pay floating. A payer swaption is an option to pay fixed and receive floating.

1.5 PARTI CI PANTS I N THE DERI VATI VES MARKETS

The following three broad categories of participants - hedgers, speculators,and arbitrageurs trade in the derivatives market. Hedgers face risk associated

with the price of an asset and they use futures or options markets to reduceor eliminate this risk. Speculators wish to bet on future movements in theprice of an asset. Futures and options contracts can give them an extra

leverage; that is, they can increase both the potential gains and potentiallosses in a speculative venture. Arbitrageurs are in business to takeadvantage of a discrepancy between prices in two different markets. If, forexample, they see the futures price of an asset getting out of line with thecash price, they will take offsetting positions in the two markets to lock in aprofit.

1.6 ECONOMI C FUNCTI ON OF THE DERI VATI VES

MARKET

Inspite of the fear and criticism with which the derivative markets arecommonly looked at, these markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to theperceived future level. The prices of derivatives converge with the prices of

the underlying at the expiration of the derivative contract. Thus derivativeshelp in discovery of future as well as current prices.


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2. The derivatives market helps to transfer risks from those who have them

but may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash

markets. With the introduction of derivatives, the underlying marketwitnesses higher trading volumes because of participation by more players

who would not otherwise participate for lack of an arrangement to transferrisk.

4. Speculative trades shift to a more controlled environment of derivatives

market. In the absence of an organized derivatives market, speculatorstrade in the underlying cash markets. Margining, monitoring andsurveillance of the activities of various participants become extremely

difficult in these kind of mixed markets.

Early forward contracts in the US addressed merchants' concerns aboutensuring that there were buyers and sellers for commodities. However 'credit

risk" remained a serious problem. To deal with this problem, a group ofChicago businessmen formed the Chicago Board of Trade (CBOT) in 1848.

The primary intention of the CBOT was to provide a centralized location

known in advance for buyers and sellers to negotiate forward contracts. In1865, the CBOT went one step further and listed the first 'exchange traded"

derivatives contract in the US, these contracts were called 'futures contracts".

In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganizedto allow futures trading. Its name was changed to Chicago Mercantile

Exchange (CME). The CBOT and the CME remain the two largest organized

futures exchanges, indeed the two largest "financial" exchanges of any kind inthe world today.

The first stock index futures contract was traded at Kansas City Board of

Trade. Currently the most popular stock index futures contract in the world isbased on S&P 500 index, traded on Chicago Mercantile Exchange. During the

mid eighties, financial futures became the most active derivative instruments

generating volumes many times more than the commodity futures. Indexfutures, futures on T-bills and Euro-Dollar futures are the three most popular

futures contracts traded today. Other popular international exchanges that

trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore,

TIFFE in Japan, MATIF in France, Eurex etc.

B o x 1 . 2 : H is t o r y o f d e r i v a t i v e s m a r k e t s

5. An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity. The derivatives have ahistory of attracting many bright, creative, well-educated people with anentrepreneurial attitude. They often energize others to create new

businesses, new products and new employment opportunities, the benefitof which are immense.


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In a nut shell, derivatives markets help increase savings and investment in

the long run. Transfer of risk enables market participants to expand theirvolume of activity.

1.7 EXCHANGE-TRADED VS. OTC DERI VATI VES

MARKETS

Derivatives have probably been around for as long as people have been trading with

one another. Forward contracting dates back at least to the 12th century, andmay well have been around before then. Merchants entered into contracts withone another for future delivery of specified amount of commodities at specifiedprice. A primary motivation for pre-arranging a buyer or seller for a stock ofcommodities in early forward contracts was to lessen the possibility that large

swings would inhibit marketing the commodity after a harvest.

As the name suggests, derivatives that trade on an exchange are called exchangetraded derivatives, whereas privately negotiated derivative contracts are called OTCcontracts.

The OTC derivatives markets have witnessed rather sharp growth over the

last few years, which has accompanied the modernization of commercial andinvestment banking and globalisation of financial activities. The recentdevelopments in information technology have contributed to a great extent to

these developments. While both exchange-traded and OTC derivative contractsoffer many benefits, the former have rigid structures compared to the latter.

The OTC derivatives markets have the following features compared to exchange-traded derivatives:

1. The management of counter-party (credit) risk is decentralized and

located within individual institutions,

2. There are no formal centralized limits on individual positions, leverage,or margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stabilityand integrity, and for safeguarding the collective interests of marketparticipants, and

5. The OTC contracts are generally not regulated by a regulatory authority

and the exchange's self-regulatory organization, although they areaffected indirectly by national legal systems, banking supervision andmarket surveillance.


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Some of the features of OTC derivatives markets embody risks to financial marketstability. The following features of OTC derivatives markets can give rise to

instability in institutions, markets, and the international financial system: (i) thedynamic nature of gross credit exposures; (ii) information asymmetries; (iii) theeffects of OTC derivative activities on available aggregate credit; (iv) the highconcentration of OTC derivative activities in major institutions; and (v) the centralrole of OTC derivatives markets in the global financial system. Instability arises

when shocks, such as counter-party credit events and sharp movements in assetprices that underlie derivative contracts occur, which significantly alter theperceptions of current and potential future credit exposures. When asset priceschange rapidly, the size and configuration of counter-party exposures can become

unsustainably large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions.

However, the progress has been limited in implementing reforms in riskmanagement, including counter-party, liquidity and operational risks, andOTC derivatives markets continue to pose a threat to international financial

stability. The problem is more acute as heavy reliance on OTC derivativescreates the possibility of systemic financial events, which fall outside themore formal clearing house structures. Moreover, those who provide OTCderivative products, hedge their risks through the use of exchange tradedderivatives.

So l v e d P r o b l e m s

Q: The largest and the most liquid financial market in the world is the

___________.

1. Equity market 3. Foreign Exchange market

2. Bond market 4. None of the above

A : The Correct Answer is 3.

Q: The standard settlement convention for Foreign Exchange Spot is

_________.

1. T+1 days 3. T+3 days

2. T+2 days 4. None of the above



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Q: Whenever the base currency buys more of the terms currency, the

base currency has __________.

1. Appreciated 3. Weakened

2. Become volatile 4. None of the above


Q: Derivatives essentially helps transfer of _______.

1. Funds 3. Goods

2. Risks 4. None of the above



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CHAPTER 2

I NTRODUCTI ON TO CURRENCYFUTURES

2.1 DEFI NI TI ON OF CURRENCY FUTURES

A futures contract is a standardized contract, traded on an exchange, to buyor sell a certain underlying asset or an instrument at a certain date in thefuture, at a specified price. When the underlying asset is a commodity, e.g.Oil or Wheat, the contract is termed a commodity futures contract. When

the underlying is an exchange rate, the contract is termed a currency futurescontract. In other words, it is a contract to exchange one currency foranother currency at a specified date and a specified rate in the future.Therefore, the buyer and the seller lock themselves into an exchange rate fora specific value or delivery date. Both parties of the futures contract must

fulfill their obligations on the settlement date.

Currency futures can be cash settled or settled by delivering the respectiveobligation of the seller and buyer. All settlements however, unlike in the caseof OTC markets, go through the exchange.

Currency futures are a linear product, and calculating profits or losses onCurrency Futures will be similar to calculating profits or losses on Indexfutures. In determining profits and losses in futures trading, it is essential toknow both the contract size (the number of currency units being traded) and

also what is the tick value. A tick is the minimum trading increment or pricedifferential at which traders are able to enter bids and offers. Tick valuesdiffer for different currency pairs and different underlyings. For e.g. in thecase of the USD-INR currency futures contract the tick size shall be 0.25paise or 0.0025 Rupees. To demonstrate how a move of one tick affects the

price, imagine a trader buys a contract (USD 1000 being the value of each

contract) at Rs.42.2500. One tick move on this contract will translate toRs.42.2475 or Rs.42.2525 depending on the direction of market movement.

Purchase price: Rs.42.2500

Price increases by one tick: +Rs.00.0025New price: Rs.42.2525

Purchase price: Rs.42.2500

Price decreases by one tick: Rs.00.0025New price: Rs.42.2475


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The value of one tick on each contract is Rupees 2.50. So if a trader buys 5contracts and the price moves up by 4 tick, she makes Rupees 50.

Step 1: 42.2600 42.2500

Step 2: 4 ticks * 5 contracts = 20 pointsStep 3: 20 points * Rupees 2.5 per tick = Rupees 50(note: please note the above examples do not include transaction fees and

any other fees, which are essential for calculating final profit and loss)

2.2 FUTURES TERMI NOLOGY

Sp o t p r i c e : The price at which an asset trades in the spot market. Inthe case of USDINR, spot value is T + 2.

Fu tu res p r i ce : The price at which the futures contract trades in thefutures market.

Cont rac t cyc le : The period over which a contract trades. The

currency futures contracts on the NSE have one-month, two-month,three-month up to twelve-month expiry cycles. Hence, NSE will have12 contracts outstanding at any given point in time.

Va lue Da te / Fi na l Se t t l emen t D a t e : The last business day of the

month will be termed the Value date / Final Settlement date of each

contract. The last business day would be taken to the same as that forInter-bank Settlements in Mumbai. The rules for Inter-bankSettlements, including those for known holidays and subsequentlydeclared holiday would be those as laid down by FEDAI (Foreign

Exchange Dealers Association of India).

Exp i r y da t e : It is the date specified in the futures contract. This is thelast day on which the contract will be traded, at the end of which it willcease to exist. The last trading day will be two business days prior to

the Value date / Final Settlement Date.

Cont rac t s i ze : The amount of asset that has to be delivered underone contract. Also called as lot size. In the case of USDINR it is USD1000.

Basis: In the context of financial futures, basis can be defined as thefutures price minus the spot price. There will be a different basis foreach delivery month for each contract. In a normal market, basis willbe positive. This reflects that futures prices normally exceed spot

prices.


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Cost o f ca r r y : The relationship between futures prices and spot pricescan be summarized in terms of what is known as the cost of carry.This measures (in commodity markets) the storage cost plus the

interest that is paid to finance or carry the asset till delivery less theincome earned on the asset. For equity derivatives carry cost is the

rate of interest.

I n i t i a l m a r g i n : The amount that must be deposited in the margin

account at the time a futures contract is first entered into is known asinitial margin.

M a r k i n g - t o - m a r k e t : In the futures market, at the end of eachtrading day, the margin account is adjusted to reflect the investor's

gain or loss depending upon the futures closing price. This is calledmarking-to-market.

Mai n tenance marg i n : This is somewhat lower than the initial margin.This is set to ensure that the balance in the margin account never

becomes negative. If the balance in the margin account falls below themaintenance margin, the investor receives a margin call and isexpected to top up the margin account to the initial margin levelbefore trading commences on the next day.

2.3 RATI ONALE FOR I NTRODUCI NG CURRENCY

FUTURES

Futures markets were designed to solve the problems that exist in forward

markets. A futures contract is an agreement between two parties to buy or sellan asset at a certain time in the future at a certain price. But unlike forwardcontracts, the futures contracts are standardized and exchange traded. To

facilitate liquidity in the futures contracts, the exchange specifies certain standardfeatures of the contract. A futures contract is standardized contract with standardunderlying instrument, a standard quantity and quality of the underlying instrument

that can be delivered, (or which can be used for reference purposes in settlement)and a standard timing of such settlement. A futures contract may be offset prior to

maturity by entering into an equal and opposite transaction.

The standardized items in a futures contract are:

Quantity of the underlying

Quality of the underlying

The date and the month of delivery


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The units of price quotation and minimum price change

Location of settlement

The rationale for introducing currency futures in the Indian context has been

outlined in the Report of the Internal Working Group on Currency Futures(Reserve Bank of India, April 2008) as follows;

The rationale for establishing the currency futures market is manifold. Both

residents and non-residents purchase domestic currency assets. If theexchange rate remains unchanged from the time of purchase of the asset toits sale, no gains and losses are made out of currency exposures. But if

domestic currency depreciates (appreciates) against the foreign currency, theexposure would result in gain (loss) for residents purchasing foreign assetsand loss (gain) for non residents purchasing domestic assets. In this

backdrop, unpredicted movements in exchange rates expose investors tocurrency risks. Currency futures enable them to hedge these risks. Nominal

exchange rates are often random walks with or without drift, while realexchange rates over long run are mean reverting. As such, it is possible thatover a long run, the incentive to hedge currency risk may not be large.However, financial planning horizon is much smaller than the long-run, whichis typically inter-generational in the context of exchange rates. As such, there

is a strong need to hedge currency risk and this need has grown manifold withfast growth in cross-border trade and investments flows. The argument forhedging currency risks appear to be natural in case of assets, and appliesequally to trade in goods and services, which results in income flows with

leads and lags and get converted into different currencies at the market rates.Empirically, changes in exchange rate are found to have very low correlationswith foreign equity and bond returns. This in theory should lower portfoliorisk. Therefore, sometimes argument is advanced against the need forhedging currency risks. But there is strong empirical evidence to suggest thathedging reduces the volatility of returns and indeed considering the episodic

nature of currency returns, there are strong arguments to use instruments tohedge currency risks.

Currency risks could be hedged mainly through forwards, futures, swaps and

options. Each of these instruments has its role in managing the currency risk.The main advantage of currency futures over it closest substitute product, viz.forwards which are traded over the counter lies in price transparency,

elimination of counterparty credit risk and greater reach in terms of easyaccessibility to all. Currency futures are expected to bring about better pricediscovery and also possibly lower transaction costs. Apart from pure hedgers,currency futures also invite arbitrageurs, speculators and those traders whomay take a bet on exchange rate movements without an underlying or an

economic exposure as a motivation for trading.


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From an economy-wide perspective, currency futures contribute to hedging of

risks and help traders and investors in undertaking their economic activity.There is a large body of empirical evidence which suggests that exchange rate

volatility has an adverse impact on foreign trade. Since there are first ordergains from trade which contribute to output growth and consumer welfare,

currency futures can potentially have an important impact on real economy.Gains from international risk sharing through trade in assets could be ofrelatively smaller magnitude than gains from trade. However, in a dynamic

setting these investments could still significantly impact capital formation in aneconomy and as such currency futures could be seen as a facilitator inpromoting investment and aggregate demand in the economy, thus promotinggrowth.

The Chicago Mercantile Exchange (CME) created FX futures, the first ever

financial futures contracts, in 1972. The contracts were created under the

guidance and leadership of Leo Melamed, CME Chairman Emeritus. The FXcontract capitalized on the U.S. abandonment of the Bretton Woods

agreement, which had fixed world exchange rates to a gold standard afterWorld War II. The abandonment of the Bretton Woods agreement resulted in

currency values being allowed to float, increasing the risk of doing business.

By creating another another type of market in which futures could be traded,CME currency futures extended the reach of risk management beyond

commodities, which were the main derivative contracts traded at CME until

then. The concept of currency futures at CME was revolutionary, and gainedcredibility through endorsement of Nobel-prize-winning economist Milton

Friedman.

Today, CME offers 41 individual FX futures and 31 options contracts on 19currencies, all of which trade electronically on the exchanges CME Globexplatform. It is the largest regulated marketplace for FX trading.

Traders of CME FX futures are a diverse group that includes multinationalcorporations, hedge funds, commercial banks, investment banks, financial

managers, commodity trading advisors (CTAs),proprietary trading firms,

currency overlay managers and individual investors. They trade in order totransact business, hedge against unfavourable changes in currency rates, or

to speculate on rate fluctuations.


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2.4 DI STI NCTI ON BETWEEN FUTURES AND

FORWARDS CONTRACTS

Forward contracts are often confused with futures contracts. The confusion is

primarily because both serve essentially the same economic functions ofallocating risk in the presence of future price uncertainty. However futureshave some distinct advantages over forward contracts as they eliminatecounterparty risk and offer more liquidity and price transparency. However, itshould be noted that forwards enjoy the benefit of being customized to meet

specific client requirements. The advantages and limitations of futurescontracts are as follows;

A d v a n t a g e s o f Fu t u r e s:

- Transparency and efficient price discovery. The market brings togetherdivergent categories of buyers and sellers.

- Elimination of Counterparty credit risk.- Access to all types of market participants. (Currently, in the Forex OTC

markets one side of the transaction has to compulsorily be an

Authorized Dealer).- Standardized products.- Transparent trading platform.

L i m i t a t i o n s o f Fu t u r e s :

- The benefit of standardization which often leads to improving liquidityin futures, works against this product when a client needs to hedge aspecific amount to a date for which there is no standard contract

- While margining and daily settlement is a prudent risk management

policy, some clients may prefer to not incur this cost in favor of OTCforwards, where collateral is usually not demanded

2.5 I NTEREST RATE PARI TY PRI NCI PLE

For currencies which are fully convertible, the rate of exchange for any dateother than spot, is a function of spot and the relative interest rates in eachcurrency. The assumption is that, any funds held will be invested in a timedeposit of that currency. Hence, the forward rate is the rate which neutralizes

the effect of differences in the interest rates in both the currencies.

The forward rate is a function of the spot rate and the interest rate differential

between the two currencies, adjusted for time. In the case of fully convertiblecurrencies, having no restrictions on borrowing or lending of either currencythe forward rate can be calculated as follows;


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Forward Rate = Spot +/- Points

Points = Spot 1 + terms i * daysbasis _ 1

1 + base i * days

basis

where i = rate of interest

In the context of currencies, like USDINR which are not fully convertible,

forwards and futures prices can be influenced by the regulation that is in placeat any given point in time.

So l v e d P r o b l e m s

Q: When an underlying is an exchange rate, the contract is termed as a______________.

1. Currency Futures contract 3. Commodity Futures

contract

2. Risks 4. None of the above


Q: A tick is the _____________ at which traders are able to enter bidsand offers.

1. maximum trading increment 3. price

2. minimum trading increment 4. None of the above


Q: Futures markets are designed to solve the problems that exist in the

____________.

1. spot markets 3. forward markets

2. options markets 4. None of the above



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Q: CME FX Futures are traded by _________________.

1. commercial banks 3. investment banks

2. hedge funds 4. All of the above



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CHAPTER 3

NSES CURRENCY DERI VATI VESSEGMENT

The phenomenal growth of financial derivatives across the world is attributedto the fulfillment of needs of hedgers, speculators and arbitrageurs by these

products. In this chapter we look at contract specifications, participants, thepayoff of these contracts, and finally at how these contracts can be used byvarious entities in the economy.

3.1 PRODUCT DEFI NI TION

RBI has currently permitted futures only on the USD-INR rates. The contract

specification of the futures shall be as under:

U n d e r l y i n g

Initially, currency futures contracts on US Dollar Indian Rupee (USD-INR)

would be permitted.

Trad i ng H o u rs

The trading on currency futures would be available from 9 a.m. to 5 p.m.

From Monday to Friday.

Size o f th e con t r ac t

The minimum contract size of the currency futures contract at the time ofintroduction would be USD 1000.

Q uo ta t i on The currency futures contract would be quoted in Rupee terms. However, theoutstanding positions would be in dollar terms.

Teno r o f t he con t rac t The currency futures contract shall have a maximum maturity of 12 months.

Ava i l ab le con t rac ts

All monthly maturities from 1 to 12 months would be made available.

Se t t l e m e n t m e ch a n i sm

The currency futures contract shall be settled in cash in Indian Rupee.

Se t t l emen t p r i ce

The settlement price would be the Reserve Bank of India Reference Rate on


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the last trading day.

Fi n al s e t t l e m e n t d a y

Would be the last working day (subject to holiday calendars) of the month.The last working day would be taken to be the same as that for Inter-bank

Settlements in Mumbai. The rules for Inter-bank Settlements, including thosefor known holidays and subsequently declared holiday would be those aslaid down by FEDAI (Foreign Exchange Dealers Association of India). In

keeping with the modalities of the OTC markets, the value date / finalsettlement date for the each contract will be the last working day of eachmonth and the reference rate fixed by RBI two days prior to the finalsettlement date will be used for final settlement. The last trading day of thecontract will therefore be 2 days prior to the final settlement date. On the last

trading day, since the settlement price gets fixed around 12:00 noon, thenear month contract shall cease trading at that time (exceptions: sun outagedays, etc.) and the new far month contract shall be introduced.

The contract specification in a tabular form is as under:

U n d e r l y i n g Rate of exchange between one USD andINR

Tr a d i n g H o u r s

( M o n d a y t o Fr i d a y )

09:00 a.m. to 05:00 p.m.

Cont rac t S ize USD 1000

Tick S ize 0.25 paise or INR 0.0025

Trad ing Pe r i od Maximum expiration period of 12 monthsCon t rac t M on ths 12 near calendar months

F i n a l S e t t l e m e n t d a t e /

V a l u e d a t e

Last working day of the month (subject toholiday calendars)

Last T rad ing Day Two working days prior to Final SettlementDate

S e t t l e m e n t Cash settled

Fina l Se t t l em en t P r i c e The reference rate fixed by RBI twoworking days prior to the final settlement

date will be used for final settlement

3.2 TRADI NG UNDERLYI NG VERSUS TRADI NG

FUTURES

The USD-INR market in India is big. Significant volumes get traded on a daily

basis. However there are certain restrictions on participation in the underlyingOTC market. Access to the USD-INR market is restricted to specified entities like


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banks, who are registered as Authorised Dealers and to other entities to have averifiable underlying commercial exposure. The primary reason for grantingaccess to the FX markets is the need to hedge FX risks. This restriction is not

applicable to the futures market.

Consider an importer of machinery from an international country where this import

is going to be denominated in dollars. The importer enters into a contract in thisregard with the exporter on say, September 01. According to the terms of thecontract an amount of USD 1 million is to be paid on November 30. Betweenthese days, the price of USD against INR is bound to fluctuate. The fluctuations

can be such that the price of USD goes up (Rupee depreciates) or the price of USDcomes down (Rupee appreciates). What if rupee depreciates? This would affectthe cost of the machinery, project cost, profitability of the deal and the profitabilityof the company as a whole.

Let us assume that the Dollar appreciated (Rupee depreciated) during this time

from Rs.44.12 to Rs.45.94. The loss on this count would have been Rs.18.20lakhs. To protect itself the company could do many things. Presumably they could

buy dollars on September 01 itself. The cost of USD 1 million works out to Rs.4.41crores. But this would have tied up a huge amount of the working capital of thecompany. The cost of funds would have been a financial drain. The company canalso book a forward contract. That would depend on its existing bankingrelationship and limits in this regard.

Instead, internationally many such companies prefer to hedge themselves againstforeign exchange fluctuations using exchange traded currency futures contracts.

Buying futures to hedge oneself against the payment currency depreciating is a

typical strategy employed globally.

In this example, let us presume that the Indian importer chose to protect itself by

buying futures. The company needed to buy 1000 contracts as one contract is ofUSD 1000. 1000 contracts amount to USD 1 million which is the same as thepayment needed to be made by the importing company and therefore would

totally offset the currency risk associated with the deal. For this purpose, only avery small portion of the total value needs to be put up as ma rgin by the importingcompany. Typically it may be around say 5%.

Because of the increase in the cost of USD against INR during this period, for the

payment on USD 1 million, the company had to pay Rs.4.594 crores as againstRs.4.412 crores. However this increase in cost was offset by the profit realized bybeing long in the futures contract. By hedging with the futures contracts the

company hedged its exposures using currency futures.

While this company bought the currency futures as it had to pay dollars, some

other company which may be receiving dollars in India and who hedged usingselling futures or an investor with a directional view or a banker who was doingarbitrage would have provided the other side of the trade.

To trade the underlying or its forward, the customer must have a relationship with

a banker who is ready to trade for him, exposure to dollar, and the associated


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documentation. In this case, it may be noted that the banker may be required totake a credit exposure on the customer.

To trade currency futures, a customer must open a futures trading account with

any of the registered members of the recognized exchanges. Buying or sellingfutures simply involves putting in the margin money. This enables the futures

traders to take a position in the underlying currency without having an underlyingexposure.

A futures contract represents a promise to transact at some point in the

future. In this light, a promise to sell currency is just as easy to make as apromise to buy currency. Selling currency futures without previously owningthe currency simply obligates the trader to selling a certain amount of theunderlying at some point in the future. It can be done just as easily as buyingfutures, which obligates the trader to buying a certain amount of the underlying at

some point in the future. However since currency futures are settled in cash, the

buying and selling does not therefore directly involve delivery of the underlyingcurrency and thus the buying or selling of the actual currency.

3.3 FUTURES PAYOFFS

A payoff is the likely profit/loss that would accrue to a market participant with

change in the price of the underlying asset. This is generally depicted in theform of payoff diagrams which show the price of the underlying asset on theX-axis and the profits/losses on the Y-axis.Futures contracts have linear payoffs. In simple words, it means that thelosses as well as profits for the buyer and the seller of a futures contract are

unlimited. Options do not have linear payoffs. Their pay offs are non-linear.These linear payoffs are fascinating as they can be combined with options andthe underlying to generate various complex payoffs. However, currently onlypayoffs of futures are discussed as exchange traded foreign currency optionsare not permitted in India.

Pa y o f f f o r b u y e r o f f u t u r e s : Lo n g f u t u r e s

The payoff for a person who buys a futures contract is similar to the payoff for

a person who holds an asset. He has a potentially unlimited upside as well asa potentially unlimited downside. Take the case of a speculator who buys atwo-month currency futures contract when the USD stands at say Rs.43.19.

The underlying asset in this case is the currency, USD. When the value ofdollar moves up, i.e. when Rupee depreciates, the long futures position starts

making profits, and when the dollar depreciates, i.e. when rupee appreciates,it starts making losses. Figure 4.1 shows the payoff diagram for the buyer ofa futures contract.


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Figure Payoff for a buyer of currency futures

The figure shows the profits/losses for a long futures position. The investor

bought futures when the USD was at Rs.43.19. If the price goes up, hisfutures position starts making profit. If the price falls, his futures positionstarts showing losses.

0

Loss

Profit

43.19

Pa y o f f f o r s e l l er o f f u t u r e s: Sh o r t f u t u r e s

The payoff for a person who sells a futures contract is similar to the payoff fora person who shorts an asset. He has a potentially unlimited upside as well as a

potentially unlimited downside. Take the case of a speculator who sells a two-month currency futures contract when the USD stands at say Rs.43.19.

The underlying asset in this case is the currency, USD. When the value of dollarmoves down, i.e. when rupee appreciates, the short futures position starts


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making profits, and when the dollar appreciates, i.e. when rupee depreciates,it starts making losses. The Figure below shows the payoff diagram for the sellerof a futures contract.

Figure Payoff for a seller of currency futures

The figure shows the profits/losses for a short futures position. The investor sold

futures when the USD was at 43.19. If the price goes down, his futures positionstarts making profit. If the price rises, his futures position starts showing losses.

0

Loss

Profit

43.19

USD

3.4 PRI CI NG FUTURES COST OF CARRY MODEL

Pricing of futures contract is very simple. Using the cost-of-carry logic, we

calculate the fair value of a futures contract. Everytime the observed pricedeviates from the fair value, arbitragers would enter into trades to capture thearbitrage profit. This in turn would push the futures price back to its fair value.

The cost of carry model used for pricing futures is given below:


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where:

r Cost of financing (using continuously compounded interest rate)T Time till expiration in years

e 2.71828

Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can beinvested at 11% p.a. The fair value of a one-month futures contract on XYZ Ltd. iscalculated as follows:

We will use the same model for pricing currency futures. However, beforethat we will see how index and stock futures are priced.

A futures contract on the stock market index gives its owner the right andobligation to buy or sell the portfolio of stocks characterized by the index.Stock index futures are cash settled; there is no delivery of the underlying

stocks.

In their short history of trading, index futures have had a great impact on theworld's securities markets. Its existence has revolutionized the art and

science of institutional equity portfolio management.

The main differences between commodity and equity index futures are that:

There are no costs of storage involved in holding equity.

Equity comes with a dividend stream, which is a negative cost if you arelong the stock and a positive cost if you are short the stock.

Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspectof dealing with equity futures as opposed to commodity futures is an accurateforecasting of dividends. The better the forecast of dividend offered by asecurity, the better is the estimate of the futures price.

Pr i c i n g i n d e x f u t u r e s g i v e n e x p e c t e d d i v i d e n d y i e l d

If the dividend flow throughout the year is generally uniform, i.e. if there are

few historical cases of clustering of dividends in any particular month, it is


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useful to calculate the annual dividend yield.

(r- q)T

F = Sewhere:

F futures price

S spot index value

r cost of financing

q expected dividend yield

T holding period

Example

A two-month futures contract trades on the NSE. The cost of financing is 10%and the dividend yield on Nifty is 2% annualized. The spot value of Nifty4000. What is the fair value of the futures contract?

(0.1- 0.02) (60 / 365)

Fair value = 4000e

= Rs.4052.95

The cost-of-carry model explicitly defines the relationship between the futuresprice and the related spot price. As we know, the difference between the spotprice and the futures price is called the basis.

Nuanc es

As the date of expiration comes near, the basis reduces - there is aconvergenceof the futures price towards the spot price. On the date of

expiration, the basis is zero. If it is not, then there is an arbitrageopportunity. Arbitrage opportunities can also arise when the basis

(difference between spot and futures price) or the spreads (differencebetween prices of two futures contracts) during the life of a contract areincorrect.

There is nothing but cost-of-carry related arbitrage that drives the

behavior of the futures price.

Transact ions costsare very important in the business of arbitrage.


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Variation of basis over time

The figure shows how basis changes over time. As the time to expiration of acontract reduces, the basis reduces. Towards the close of trading on the day ofsettlement, the futures price and the spot price converge. The closing price for theJune 28 futures contract is the closing value of Nifty 50 on that day.

3.5 PRI CI NG STOCK FUTURES

A futures contract on a stock gives its owner the right and obligation to buy orsell the stocks. Like index futures, stock futures are also cash settled; there is

no delivery of the underlying stocks. Just as in the case of index futures, themain differences between commodity and stock futures are that:

There are no costs of storage involved in holding stock. Stocks come with a dividend stream, which is a negative cost if you are

long the stock and a positive cost if you are short the stock.

Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect

of dealing with stock futures as opposed to commodity futures is an accurateforecasting of dividends. The better the forecast of dividend offered by a

security, the better is the estimate of the futures price.

Pr i c i n g st o c k f u t u r e s w h e n n o d i v i d e n d e x p e ct e d

The pricing of stock futures is also based on the cost-of-carry model, wherethe carrying cost is the cost of financing the purchase of the stock, minus thepresent value of dividends obtained from the stock. If no dividends are

expected during the life of the contract, pricing futures on that stock is verysimple. It simply involves multiplying the spot price by the cost of carry.


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Example

XYZ futures trade on NSE as one, two and three- month contracts. Money canbe borrowed at 10% per annum. What will be the price of a unit of new two-

month futures contract on SBI if no dividends are expected during the two-month period?

1. Assume that the spot price of XYZ is Rs.228.

0.10 (60/365)

2. Thus, futures price F = 228e

= Rs.231.90

Pr i c i n g st o c k f u t u r e s w h e n d i v i d e n d s a r e e x p e ct e d

When dividends are expected during the life of the futures contract, pricinginvolves reducing the cost of carry to the extent of the dividends. The netcarrying cost is the cost of financing the purchase of the stock, minus thepresent value of dividends obtained from the stock.

Example

XYZ futures trade on NSE as one, two and three-month contracts. What willbe the price of a unit of new two-month futures contract on XYZ if dividendsare expected during the two-month period?

1. Let us assume that XYZ will be declaring a dividend of Rs. 10 per shareafter 15 days of purchasing the contract.

2. Assume that the market price of XYZ is Rs. 140.

3. To calculate the futures price, we need to reduce the cost-of-carry to theextent of dividend received. The amount of dividend received is Rs.10. The

dividend is received 15 days later and hence compounded only for theremainder of 45 days.

4. Thus, futures price =

0.1 (60/365) 0.1 (45/365)

F = 140e - 10e

= Rs.132.20


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The strategy therefore leaves a risk less profit of Rs.900.91

Suppose the rate was greater than 45.34 as given in the equation above, the

reverse strategy would work and yield risk less profit.

It may be noted from the above equation, if foreign interest rate is greater

than the domestic rate i.e. rf > r, then F shall be less than S. The value of Fshall decrease further as time T increase.

If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of

F shall be greater than S. The value of F shall increase further as time Tincreases.

Note : While the above is the theoretical position, in a scenario where capital

flows are not unrestricted, as in India, the interest rate differential modelwould need to be modified somewhat. For the domestic yield (r), it may be

necessary to employ MIFOR rates (which are a function of forward rates)instead of nominal rates, while USD yield (rf) would be the nominal rate asper LIBOR, or any other equivalent published international source.

3.7 PARTICI PANTS AND FUNCTIONS

The participants in this segment shall prima-facie include all the entities who

directly or indirectly have exposure to the foreign exchange movements.

Any importer or exporter of goods and services has exposure to foreign currency

risk. These entities shall find this product useful for hedging their risks. Theentities shall include corporates importing machinery / raw materials or paying forservices to an offshore entity, and corporates exporting their products and servicesabroad. Therefore all entities having trade or capital related flows denominated inforeign currency will have an interest in using this product.

The share holders and creditors of these companies also may be indirectly

exposed to the currency risk and hence may find the product useful.

Any entity using such goods and services whose price is exposed to foreign

exchange movements may also find this useful. For example, entities who

procure, say oil or metals like say zinc, copper, etc. locally, are not importers.However the price of oil and metals are dependant on international pricemovement and hence expose these users to foreign currency risks. Hence entitieswho are directly importers or exporters or entities having an indirect or derived

exposure are potential users of exchange traded futures. These type of entitieswho hedge their exposure to foreign currency using currency futures are called asHedgers.

Apart from hedgers, people who have directional view on the USD-INR movement

may also like to trade currency futures. Given the various economic conditions,some of the users may feel that rupee shall appreciate while others may feel the


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reverse. These entities are called as speculators and they may also like to trade.

Further, entities that are permitted to trade both in the forward market and

futures market may be able to identify mis-pricing of the contract and trade inboth the markets to benefit from such mis-pricing. These entities are called asarbitrageurs.

3.8 USES OF CURRENCY FUTURES

Hedging:

Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. Wants

to lock in the foreign exchange rate today so that the value of inflow in Indianrupee terms is safeguarded. The entity can do so by selling one contract of USD-INR futures since one contract is for USD 1000.

Presume that the current spot rate is Rs.43 and USDINR 27 Aug 08 contract is

trading at Rs.44.2500. Entity A shall do the following:

Sell one August contract today. The value of the contract is Rs.44,250.

Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The

entity shall sell on August 27, 2008, USD 1000 in the spot market and get Rs.44,000. The futures contract will settle at Rs.44.0000 (final settlement price =RBI reference rate).

The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs.

44,000). As may be observed, the effective rate for the remittance received by theentity A is Rs.44.2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that datewas Rs.44.0000. The entity was able to hedge its exposure.

Speculation: Bull ish, buy fu tu res

Take the case of a speculator who has a view on the direction of the market. He would

like to trade based on this view. He expects that the USD-INR rate presently atRs.42, is to go up in the next two-three months. How can he trade based on thisbelief? In case he can buy dollars and hold it, by investing the necessary capital, he

can profit if say the Rupee depreciates to Rs.42.50. Assuming he buys USD 10000,it would require an investment of Rs.4,20,000. If the exchange rate moves as heexpected in the next three months, then he shall make a profit of around Rs.5000.This works out to an annual return of around 4.76%. It may please be noted thatthe cost of funds invested is not considered in computing this return.

A speculator can take exactly the same position on the exchange rate by using

futures contracts. Let us see how this works. If the INR- USD is Rs.42 and thethree month futures trade at Rs.42.40. The minimum contract size is USD 1000.Therefore the speculator may buy 10 contracts. The exposure shall be the same as


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above USD 10000. Presumably, the margin may be around Rs.21,000. Threemonths later if the Rupee depreciates to Rs. 42.50 against USD, (on the day ofexpiration of the contract), the futures price shall converge to the spot price (Rs.

42.50) and he makes a profit of Rs.1000 on an investment of Rs.21,000. This worksout to an annual return of 19 percent. Because of the leverage they provide,

futures form an attractive option for speculators.

Speculat ion: Bear ish, se l l fu t ures

Futures can be used by a speculator who believes that an underlying is over-valued

and is likely to see a fall in price. How can he trade based on his opinion? In the

absence of a deferral product, there wasn't much he could do to profit from hisopinion. Today all he needs to do is sell the futures.

Let us understand how this works. Typically futures move correspondingly with the

underlying, as long as there is sufficient liquidity in the market. If the underlying

price rises, so will the fut ures price. If the underlying price falls, so will thefutures price. Now take the case of the trader who expects to see a fall in theprice of USD-INR. He sells one two-month contract of futures on USD say at Rs.

42.20 (each contact for USD 1000). He pays a small margin on the same. Twomonths later, when the futures contract expires, USD-INR rate let us say is Rs.42.On the day of expiration, the spot and the futures price converges. He has madea clean profit of 20 paise per dollar. For the one contract that he sold, thisworks out to be Rs.200.

A r b i t r a g e :

Arbitrage is the strategy of taking advantage of difference in price of the

same or similar product between two or more markets. That is, arbitrage isstriking a combination of matching deals that capitalize upon the imbalance,the profit being the difference between the market prices. If the same orsimilar product is traded in say two different markets, any entity which has

access to both the markets will be able to identify price differentials, if any.If in one of the markets the product is trading at higher price, then the entityshall buy the product in the cheaper market and sell in the costlier marketand thus benefit from the price differential without any additional risk.

One of the methods of arbitrage with regard to USD-INR could be a tradingstrategy between forwards and futures market. As we discussed earlier, thefutures price and forward prices are arrived at using the principle of cost of

carry. Such of those entities who can trade both forwards and futures shallbe able to identify any mis-pricing between forwards and futures. If one ofthem is priced higher, the same shall be sold while simultaneously buying theother which is priced lower. If the tenor of both the contracts is same, sinceboth forwards and futures shall be settled at the same RBI reference rate, the

transaction shall result in a risk less profit.

Solved Prob lem s


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Q: On 15th January Mr. Arvind Sethi bought a January USDINR futurescontract which cost him Rs.42,000. Each USDINR futures contract is fordelivery of USD1000. The RBI reference rate for final settlement was fixed

as 42.10. How much profit/loss did he make?

1. +6000 3. -300

2. -4500 4. +100

A: Mr. Sethi bought one futures contract costing him Rs.42,000. At a market

lot of 1000, this means he paid Rs.42 per USD. On the futures expirationday, the futures price converges to the spot price. The reference rate forfinal settlement is fixed as 42.10. Hence he will have made of profit of

(42.10 42.00)* 1000. The correct answer is number 4.

Q: Kantaben sold a August USDINR futures contract for Rs.42,000 on 15thJanuary. Each USDINR futures contract is for delivery of USD1000. The RBI

reference rate for final settlement was fixed as 42.10. How much profit/lossdid she make?

1. -300 3. +300

2. -100 4. +100

A: Kantaben sold one futures contract costing her Rs.42,000. At a market lot

of 1000, this means she paid Rs.42 per USD. On the futures expiration

day, the futures price converges to the spot price. The reference rate forfinal settlement is fixed as 42.10. Hence she will have made a loss of(42.00 42.10)* 1000. The correct answer is number 2.

Q: A speculator with a bullish view on USD-INR rate can _________.

1. buy USD INR futures 3. sell USD INR futures

2. buy index futures 4. sell index futures

A: The correct answer is number 1.

Q: Application of Currency Futures include ________________.

1. Hedging 3. Speculation

2. Arbitrage 4. All of the above



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CHAPTER 4

TRADI NGIn this chapter we shall take a brief look at the trading system for NSE'sCurrency Derivatives segment. However, the best way to get a feel of thetrading system is to actually watch the screen and observe trading.

4.1 CURRENCY DERI VATI VES TRADING SYSTEM

The Currency Derivatives trading system of NSE, called NEAT-CDS (National

Exchange for Automated Trading Currency Derivatives Segment) trading

system, provides a fully automated screen-based trading for currency futureson a nationwide basis as well as an online monitoring and surveillance

mechanism. It supports an order driven market and provides completetransparency of trading operations. The online trading system is similar tothat of trading of equity derivatives in the Futures & Options (F&O) segmentof NSE.

The software for the Currency Derivatives segment has been developed tofacilitate efficient and transparent trading in Currency Derivatives

instruments. Keeping in view the familiarity of trading members with thecurrent F&O trading system, modifications have been performed in the

existing F&O trading system so as to make it suitable for trading currencyfutures.

4 .1 .1 En t i t i es i n t he t r ad ing syst em

There are four entities in the trading system. Trading members, clearing

members, professional clearing members and participants.

1) T r a d i n g m e m b e r s ( T M ) : Trading members are members of NSE.They can trade either on their own account or on behalf of their clientsincluding participants. The exchange assigns a trading member ID to

each trading member. Each trading member can have more than oneuser. The number of users allowed for each trading member is notifiedby the exchange from time to time. Each user of a trading membermust be registered with the exchange and is assigned an unique userID. The unique trading member ID functions as a reference for all

orders/trades of different users. This ID is common for all users of aparticular trading member. It is the responsibility of the trading member tomaintain adequate control over persons having access to the firms User IDs.


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2) Clear ing m em bers ( CM):Clearing members are members of NSCCL. Theycarry out risk management activities and confirmation/inquiry ofparticipant trades through the trading system.

3) Professional c lear ing members (PCM): A professional clearing

members is a clearing member who is not a trading member. Typically,banks and custodians become professional clearing members and clear andsettle for their trading members and participants.

4) Par t i c i pan ts : Aparticipant is a client of trading members like financialinstitutions. These clients may trade through multiple trading membersbut settle through a single clearing member.

Figu re 4 .1 M ark e t by p r i c e i n NEAT CDS


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4.1 .2 Basis o f t rad in g

The NEAT-CDS system supports an order driven market, wherein orders

match automatically. Order matching is essentially on the basis of security, itsprice and time. All quantity fields are in contracts and price in Indian rupees.

The exchange notifies the contract size and tick size for each of the contractstraded on this segment from time to time. When any order enters the tradingsystem, it is an active order. It tries to find a match on the opposite side of

the book. If it finds a match, a trade is generated. If it does not find a match,the order becomes passive and sits in the respective outstanding order bookin the system.

4.1 .3 Corp ora t e h ie ra r chy

In the trading software, a trading member has the facility of defining ahierarchy amongst users of the system. This hierarchy comprises corporatemanager, branch manager and dealer.

1) C orpo ra te manage r : The term 'Corporate manager' is assigned to auser placed at the highest level in a trading firm. Such a user canperform all the functions such as order and trade related activities,receiving reports for all branches of the trading member firm and alsoall dealers of the firm. Additionally, a corporate manager can define

limits for the branches and dealers of the firm.

2) Branch manage r : The branch manager is a term assigned to a user

who is placed under the corporate manager. Such a user can performand view order and trade related activities for all dealers under that

branch. Additionally, a branch manager can define limits for thedealers under that branch.

3) Dealer : Dealers are users at the lower most level of the hierarchy. Adealer must be linked either with the branch manager or corporate

manager of the firm. A Dealer can perform view order and trade relatedactivities only for oneself and does not have access to information onother dealers under either the same branch or other branches.

Below given cases explain activities possible for specific user categories:

Co r p o r a t e m a n a g e r o f t h e c l e ar i n g m e m b e r

Corporate manager of the clearing member has limited rights on the tradingsystem. A corporate manager of the clearing member can perform following

functions:


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On line custodian/ give up trade confirmation/ rejection for theparticipants

Limit set up for the trading member / participants

View market information like trade ticker, Market Watch etc. View net position of trading member / Participants

Co r p o r a t e Ma n a g e r o f t h e t r a d i n g m e m b e r

This is the top level of the trading member hierarchy with trading right. A

corporate manager of the trading member can broadly perform followingfunctions:

Order management and trade management for self View market information

Set up branch level and dealer level trading limits for any branch/ dealerof the trading member

View, modify or cancel outstanding orders on behalf of any dealer of thetrading member

View, modify or send cancel request for trades on behalf of any dealer of

the trading member View day net positions at branch level and dealer level and cumulative

net position at firm level

B r an c h m a n a g e r o f t r a d i n g m e m b e r

The next level in the trading member hierarchy with trading right is the branchmanager. One or more dealers of the trading member can be a branch managerfor the trading member. A branch manager of the trading member can broadlyperform the following functions:

Order management and trade management of self View market information Set up dealer level trading limits for any dealer linked with the branch View, modify or cancel the outstanding orders on behalf of any dealers

linked with the branch View, modify or send cancel request for trades on behalf of any dealer of

the dealer linked with the branch View day net positions at branch level and dealer level

D ea l er o f a t r a d i n g m e m b e r

The dealer is at the last level of the trading member hierarchy with tradingright. The dealer can be set up either under a branch manager or corporatemanager. A dealer of the trading member can broadly perform the followingfunctions:


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Order management and trade management of self View market information Set up order level trading limits for self

View net position Back up of online orders and trades for self

4.1 .4 Cl ien t Brok er Re la t ionsh ip in Der iva t i v es Segm ent

A client of a trading member is required to enter into an agreement with thetrading member before commencing trading. A client is eligible to get all the

details of his or her orders and trades from the trading member. A tradingmember must ensure compliance particularly with relation to the followingwhile dealing with clients:

1. Filling of 'Know Your Client' form

2. Execution of Client Broker agreement

3. Bring risk factors to the knowledge of client by getting acknowledgement ofclient on risk disclosure document

4. Timely execution of orders as per the instruction of clients in respective clientcodes.

5. Collection of adequate margins from the client

6. Maintaining separate client bank account for the segregation of client money.

7. Timely issue of contract notes as per the prescribed format to the client

8. Ensuring timely pay-in and pay-out of funds to and from the clients

9. Resolving complaint of clients if any at the earliest.

10. Avoiding receipt and payment of cash and deal only through account payeecheques

11. Sending the periodical statement of accounts to clients

12. Not charging excess brokerage

13. Maintaining unique client code as per the regulations.


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4 .1 .5 Orde r t y pes and cond i t i ons

The system allows the trading members to enter orders with variousconditions attached to them as per their requirements. These conditions are

broadly divided into the following categories:

Time conditions

Price conditions

Other conditions

Several combinations of the above are allowed thereby providing enormousflexibility to the users. The order types and conditions are summarized below.

Figu re 4 .2 Market Inquiry


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Ti m e c on d i t i o n s

- D ay o rde r : A day order, as the name suggests is an order

which is valid for the day on which it is entered. If the order isnot executed during the day, the system cancels the order

automatically at the end of the day.- I m m e d i at e o r Ca n ce l ( I OC) : An IOC order allows the user tobuy or sell a contract as soon as the order is released into the

system, failing which the order is cancelled from the system.Partial match is possible for the order, and the unmatchedportion of the order is cancelled immediately.

Pr i c e c o n d i t i o n

- Stop- loss : This facility allows the user to release an order intothe system, after the market price of the security reaches or

crosses a threshold price e.g. if for stop-loss buy order, thetrigger is 42.0025, the limit price is 42.2575 , then this order is

released into the system once the market price reaches orexceeds 42.0025. This order is added to the regular lot bookwith time of triggering as the time stamp, as a limit order of42.2575. Thus, for the stop loss buy order, the trigger price hasto be less than the limit price and for the stop-loss sell order,

the trigger price has to be greater than the limit price.

Ot h e r co n d i t i o n s

- Marke t p r i ce : Market orders are orders for which no price isspecified at the time the order is entered (i.e. price is marketprice). For such orders, the trading system determines theprice.

- Tr i g g e r p r i c e : Price at which an order gets triggered from thestop-loss book.

- L im i t p r i ce : An order to a broker to buy a specified quantity ofa security at or below a specified price, or to sell it at or above

a specified price (called the limit price). This ensures that aperson will never pay more for the stock than whatever price isset as his/her limit. It is also the price of orders after triggeringfrom stop-loss book.

- Pro: Pro means that the orders are entered on the tradingmember's own account.

- Cli: Cli means that the trading member enters the orders onbehalf of a client.


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4.2 THE TRADER WORKSTATION

4 .2 .1 Th e m a r k e t w a t ch w i n d o w

The following windows are displayed on the trader workstation screen:

Title bar Menu Bar Toolbar

Ticker window of Currency Derivatives segment Ticker window of spot market Market watch window Inquiry window Snap quote

Order/trade window System message window

As mentioned earlier, the best way to familiarize oneself with the screen andits various segments is to actually spend some time studying a live screen. In

this section we shall restrict ourselves to understanding just two segments ofthe workstation screen, the market watch window and the inquiry window.

The market watch window is the fifth window from the top of the screenwhich is always visible to the user. This is the main window from the dealer's

perspective. The purpose of market watch is to allow continuous monitoring

of contracts that are of specific

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